Friday, February 15, 2013

ONEOK Partners, L.P. (OKS) engages in the gathering, processing, storage, and transportation of natural gas in the United States. The partnership has paid distributions since 1994, and increased them every year since 2006.

ONEOK Partners is a master limited partnership (MLP), which is a pass through corporate structure. As such, profits are not taxed at the entity level, but at the individual partner level. Investors in MLPs are called limited partners, shares are called units and dividends are called distributions. As a result of the fact that the net results are taxed at the individual partner level, the taxation of these distributions could be slightly more challenging when compared to taxation of dividends from typical dividend stocks such as Chevron (CVX) for example. ONEOK (OKE) is the general partner and owner of 43.40% in ONEOK Partners (OKS).

I replaced my investment in ONEOK Inc (OKE) for ONEOK Partners (OKS) units in 2011. In 2012 I sold the majority of my shares in Con Edison (ED) and bought more units of ONEOK Partners with the proceeds. You can read my arguments behind the trade in this article.

The partnership operates in three major segments:

Natural Gas Gathering and Processing Segment- Provides nondiscretionary services to producers
that include gathering and processing of natural gas produced from crude oil and natural gas wells. Revenues from this segment are derived primarily from POP and fee contracts. Under a POP contract, ONEOK retains a percentage of the NGLs and/or a percentage of the residue gas as payment for gathering, treating, compressing and processing the producer’s natural gas. While the partnership is exposed to commodity price risk in this segment, it is mitigated by the fact that the majority of exposure is hedged. This segment is expected to deliver approximately 25% of operating income in 2013.

Natural Gas Liquids Segment - Provide nondiscretionary services to producers that consist of facilities that gather, fractionate and treat NGLs and store NGL products primarily in Oklahoma, Kansas and Texas. Revenues for our Natural Gas Liquids segment are derived primarily from fee-based services provided to customers and physical optimization of assets. Physical optimization is a fancy term to describe purchase and transportation of NGL products in order to realize market or seasonal differentials in pricing. This segment is expected to account for over 60% of operating income in 2013.

Projected distribution and earnings growth are expected to be driven primarily by natural gas and natural gas liquids volume growth. The partnership also expects higher anticipated natural gas gathering and processing volumes and increased natural gas liquids gathering volumes as several projects from its $5.7 billion to $6.6 billion, four-year growth program are placed into service.

Approximately $1.5 billion to $1.8 billion will be spent to to construct a 1,300-mile crude-oil pipeline to transport light-sweet crude oil from the Bakken Shale in the Williston Basin in North Dakota to the Cushing, Okla., crude-oil market hub. Construction is expected to begin in late 2013 or early 2014 and be completed by early 2015. In addition, approximately $2.4 billion to $2.9 billion for natural gas liquids projects expected to inservice between 2013- 2015. The remaining $1.8 billion to $1.9 billion for natural gas gathering and processing projects mostly in the Bakken Shale.

Since 2005, ONEOK Partners has managed to boost distributions by 7.10% per year. The partnership expects 10% – 15% annual distribution growth through 2015 and plans to maintain at least a 1.05 times distributable cash flow coverage. Per its partnership agreement, the majority of available cash from operations should be distributed to general and limited partners.

Master limited partnerships such as ONEOK Partners have a geographic competitive advantage. The entry costs to build a pipeline and connect oil and gas wells with processing facilities is in the hundreds of millions if not several billions. The steep fee is a deterrent to competition, since running two pipelines adjacent to each other would not be profitable for either party. The business is heavily regulated by FERC, which sets rates to allow recovery of investment plus a proscribed rate of return.

There are several risks to investing in MLPs such as ONEOK Partners. Because the business is capital intensive in nature, and requires a lot of capital for future investment, increase in interest rates would reduce distributable cash flows per unit. The partnership distributes almost all of its cash flows to unitholders, which is why it finances growth through sale of debt or sale of additional units. Another risk involves government regulation, such as abolishment of MLP structure for example. This could lead to taxation of profits at the MLP level and the shareholder level, which would lead to distribution cuts. Distribution cuts would probably lead to decrease in unit prices, similar to what happened with Canadian Royalty Trusts in 2006.

A large portion of the distribution paid to limited partners is usually classified as a return of capital. This lowers the partner’s basis, until it reaches zero. As a result, a large part of the distribution received by the partners is tax deferred for a period of time. This is caused by the depreciation on long-term assets such as pipelines. Partners receive a K-1 form each year, which is slightly more complicated than a 1099 –Div form. When I filed my tax returns for 2011 however, the partnership sent me a pretty useful tax package, which visualized how I need to report the amounts from the K-1 package.

Currently, ONEOK Partners yields 4.80%, which is somewhat lower in comparison with other MLPs. However, the strong distribution growth more than compensates for low current yield. I would consider adding to my position subject to availability of funds.

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